A Better Way To View Stock Market Risk

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(alternate title: Don’t Put Your Roth IRA into CDs or Cash!)

The prospect of losing your hard-earned money is scary. You know that if you invest with $1000 in stocks, in a year you could be left with either a huge gain or a huge loss. People (including me in the past) tend to look at the stock market like a slot machine:

This is good in that, yes, for the short-term the stock market is risky. Don’t put money you may need right away into stocks. However, when young people tell me that they are putting their Roth IRAs in a bank CD because they are afraid of the stock market, that is bad. Roth IRAs are long-term investments. We’re talking 30, 40, 60 years for some people! The way you should be looking at the stock market is this:

As you can see, as your time-horizon lengthens, your risk of losing money decreases significantly. When looking back and taking any 25-year period between 1950 and 1994, the worse case still gave you a 7.9% annualized return. Note that the average for all of these time periods is still the same, 10% per year. So what you’re really looking at is something more like:

Although we may not get that same 10% average in the future, I think it’s clear that you need to make your horizon as long as possible by starting now. Remember, even though you may track your investments daily, most of you are not going to actually touch them for decades, so it doesn’t matter what happens next year. What matters is that you were “in the game” for that year, extending your time period in the market, rocky or not. Also, this is just stocks – We are not even taking into the account the additional tempering effect of incorporating bonds to your portfolio.

Finally, consider this. Right now, bank CDs paying 6% in some cases may seem nice. But after inflation, the long-term return of cash-equivalents like bank accounts or Treasury Bills is… zero. By not investing in stocks (again, for long periods), you are giving yourself a 100% chance of making nothing. IRAs, 401ks, 403bs, TSPs, they are all for the long-run. Get in the game!

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Comments

Agreed! It’s so important to realize that there are 2 risks involved in long-term investing – 1. you lose your principal, and 2. your gains can’t keep up with inflation. It’s easy to focus on the first risk without paying attention to the second. Love the chart!

This is an excellent way of looking at stock market risk, although including only the last 50 years makes the possible losses look better than they would if the 1930’s were included. For example, using the Dow Industials as the market index, the worst 25-year performance would’ve been -12% (-0.5% annualized) between August 1929 (Dow=380.33) and August 1954 (Dow=335.80). It’s comforting to look at the last 50 years and say that every bear market is followed by a bigger bull, but there was a time in our history where that wasn’t the case. As they say, “past performance is no guarantee of future results!”

When you are looking at returns, what really matters is real returns after inflation. For example, what Chris said about the 25 year period during the Great Depression is probably true if measured by stock prices, but it is an incomplete picture. During that time there was massive deflation (the opposite of inflation). Just as inflation erodes real returns, deflation would boost real returns. Compared to other investments, such as cash, stocks did realtively well over that 25 year period. If someone had the time to find the data, it would be neat to actually see a real-return chart similar to the one Johnathan posted above.

It’s misleading that the data only looked at from 1950-1994, some of the greatest growth of the nation. If the data started from the 1920s, then the worst 25 year span would have been negative. Is the U.S. going to continue to grow as much in the next 50 years?

Or take a look at the Nikkei. In a 20 year span from 1984-2004, it was also negative.

These are not annualized (they are cumulative), and they are not inflation-adjusted.

By the way for small value, the worst period gains were:
I don’t agree that the graph is misleading. I just did my own analysis of the S&P 500 and a small-value index from 1927 to today. For the S&P 500:

This is probably good advice for the masses, but not if you are trying to time the market. There are always periods of ups and downs. After a long run it is typical for some kind of downward trend. In other words: it would have been much better to have been in CDs and treasuries in the couple of years following beginning of 2000.

excellent analysis, and perfectly illustrative for someone who is investing in a target retirement fund (trowe) and letting it coast. you would think these are the same data sets that fund managers and employees are using to develop their strategies to target return. Nice post for those of us that don’t have time to “time” the market.

I totally agree that past performance is not a guarantee of the future. However, we are not talking about the 1-year performance of some hot fund here. All any of us can do is put our money in the place that has the best chance for success. And by examining 80 years of data, we can gain much more confidence.

The narrowing of the range bands as with the increase in time periods (or reversion to the mean) has been true since stock prices have been tracked. While the numbers may be different depending on what specifically you are looking at, the reduction of risk with time remains.

I have a question, I have money sitting around, I want to buy my first house, but my money is in a 4% savings account…I hear all this talk about stock market, mutual funds, what is the best idea to make nice appreciation for about 2 years so I can take that money out?

No one can time the market but there are some moves which can be made to improve your odds of having success. When rebalancing your portfolio or when investing new money, the natural tendency is to buy more shares of the “high flyers” and sell shares of the “losers.” This strategy is inviting disaster.

Remember to buy “low” and sell “high.” If your small cap holdings have soared, it might be wise to divert a portion of the earnings into an area where you are under invested–ie. large caps.

This is an excellent point that people need to understand. Things might be rocky with the stock market in 1-5 year stretches. But if you look at the stock market in ten years intervals, every time it goes up. It may be a little or it may be a lot, but it always goes up. And, chances are it’s only going to continue to do the same.

It is interesting to note that if you measure risk by the volatility of end balances, the stock market is actually RISKIER the longer you invest since a 1-2% per year difference in return can make a huge difference in your final balance over 40 or 50 years. It’s all about perspective.

OK – I understand that stocks are the way to go for the long term…but what about the short term when the market has tanked?

For example, if my 401K was worth $100,000 on Jan 1, 2008 and on July 1 it is only worth $85K, shouldn’t I pull out half of the remnant and put it in a CD or bond that gains SOMETHING (even 3%?) for the next 3 to 5 months? And then put it all back in the market ?

You’re analysis is extremely flawed for many reasons. Most notably you don’t take into account the survivorship bias inherent in an index like the S&P 500. In other words, the tendency for failed companies to be excluded from the index performance due to the fact that they no longer exist. By not considering the survivorship bias, you greatly overstate the returns and grossly understate the risk involved.

Consider this sobering statistic: Of the five hundred largest U.S, Companies in 1957, only 74 were still part of that select group, the Standard and Poor’s 500, forty years later (The Black Swan by Nassim Taleb).

If this does not make you queasy about investing in the “promising” stock market, I would suggest having your head examined.

That’s a 44 time period that only includes a post war bull market. Without the Great Depression, the Dot Com Bubble or the current financial crisis, this data tells us nothing.

Actually, people investing their own money in the market or just buying index funds or mutual funds is a stupid idea, but instead of giving us reliable data, you just pulled data from a 44 year period… that’s too short of time period to be reliable and is definitely not predictive of the future of America or the US Stock Market….

To place this in a universe of alternative outcomes, it would be interesting to see these calculations applied to the Nikkei index over the same period of time. You may in fact reach the same conclusion but the volatility between 1985 and 2005 might provide insights for possible future outcomes. This site can be used for the data:http://indexes.nikkei.co.jp/en/nkave/archives/data

At the end of the day it is all a risk vs. reward equation. The 10 year treasury can be used as a benchmark for what Mr. Market is currently pricing very low risk at.

The risk in all of this is assuming that the future of the US market will be like it’s past, and not like the past of another market. For example using the Nikkei 225 from 1950 to the present you would get:

1 year -39.7 to 116.11
5 year -10.26 to 63.39
10 year -5.57 to 122.88
15 year -4.69 to 85.91
20 year -3.64 to 103.65
25 year -2.20 to 166.76

Do you then reach the same conclusions you reached with US market data?
Is there a reason to believe what happened in Japan could never happen here?

Great article. I agree with that people have to diversify and I have to say that if you want to invest, let say in the stocks market is good to be value investor, or in other words to invest for middle or long periods of time. I think this is the key to successful investing.

This is excellent – the long-term perspective is very useful for novice investors who tend to have a short-term outlook too much. However, there’s a small and important caveat – to get the returns in your graph you actually have to stay invested proper over the long term. No one will get that 25 year return if they keep entering and exiting stock positions all the time or betting on random stocks or doing any of the other foolish things that plague portfolios around the world. Basically, a bit of discipline is required to get good results in the stock market over the long term.

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